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Coping with the New 3.8% Medicare Surtax

Some high-income investors face a “tax increase” this year that has nothing to do with the new American Taxpayer Relief Act (ATRA). Under the Patient Protection and Affordable Care Act of 2010 (PPACA), you may be liable for a 3.8% Medicare surtax on a portion of your income, beginning in 2013. The IRS recently issued new proposed regulations explaining the rules.

Background: The 3.8% Medicare surtax applies to the lesser of your net investment income (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. For example, if you are a single filer with $150,000 in NII and a MAGI of $300,000 in 2013, the surtax is $3,800 (3.8% of $100,000 excess MAGI). Note: The surtax for trusts and estates applies to the lesser of undistributed NII or adjusted gross income (AGI) above the dollar amount for the top income tax bracket for trusts and estates.

Now that ATRA has increased the top income tax rate to 39.6% in 2013, you could pay a combined federal tax rate of 43.4% (39.6% plus 3.8%) on some income.

The PPACA definition of NII includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities. But other items—such as wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a nonpassive business, and distributions from qualified retirement plans and IRAs—are excluded.

The new regulations clarify several issues relating to the 3.8% surtax. Consider this:

Gains: Generally, a gain that is not recognized for other federal income tax purposes does not count as NII. This includes gain deferred under an installment sale, gain from like–kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount ($250,000 for single filers and $500,000 for joint filers).

NII exceptions: Items normally considered NII, such as dividends or interest, are not treated as NII if they are derived in the ordinary course of a trade or business. But this exception requires that the business not be a passive activity or be trading in financial instruments or commodities.

For a sole proprietor, the test is applied at the individual level. For a taxpayer owning an interest in a pass-through entity—such as an S corporation or partnership—the passive activity test is applied at the taxpayer level, but the financial trading test is applied at the entity level.

Estates and trusts: The surtax applies to ordinary trusts, but not tax-exempt trusts. Also, it does not apply to grantor trusts (although grantor trust income is treated as being received by the grantor). A charitable remainder trust is not subject to the surtax, but distributions to the trust’s income beneficiary may be treated as NII for this purpose. Furthermore, foreign estates and trusts are not subject to the surtax.

Final advice: Be aware that certain types of income not treated as NII may be “swept in” under other rules. For instance, rental income that is exempt under the passive activity exception may be subject to NII if the rental income is not derived in the ordinary course of a trade or business. Obtain professional assistance for your situation.

 

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